How will Solvency II Impact Insurers? A Primer

Introduction

Solvency II is the new European Directive for European insurers (and reinsurers) that will address their capital requirements and supervision. It will introduce a consistent and strengthened set of rules across Europe with the aim of significantly reducing the probability of firm failure and, as a result, lead to significant improvement in policyholder protection.

The new Directive will be based on a modern, risk-based approach that relies upon market consistent methods for the valuation of insurers' assets and liabilities. It will replace existing regulations which are based on Solvency I and, in many cases, supplemented with additional risk based requirements that have been phased in over time by local regulators.

Solvency II is expected to come in to force in January 2013.


The Framework

Like the Basel framework for banks, the Solvency II requirements are grouped as pillars. The 3 pillars will address quantitative requirements, qualitative review and monitoring, and disclosure.

covers the quantitative requirements. The aim of this pillar is to ensure that all firms are sufficiently capitalised. It stipulates how a firm must calculate its insurance liabilities as well as providing guidelines on how the firm calculates solvency metrics.

Under Solvency II insurers will be required to hold assets that are equal to the sum of their insurance liabilities, other liabilities and their calculated solvency requirement. Solvency II encourages that all valuations are on a market consistent basis; assets are required to be valued at "the amount for which they could be exchanged between knowledgeable willing parties in an arm's length transaction" and liabilities are required to be valued at "the amount for which they could be transferred, or settled, between knowledgeable willing parties in an arm's length transaction".¹ This suggests that valuations should generally be consistent with IFRS where this leads to an appropriate economic value. Where there are observable market values then mark to market valuations must be used, if there are no observable prices then a model calibrated to be consistent with what can be observed in the market should be used.

To ensure the quality of the asset base a prudent person principle applies. This will require insurers to only invest in assets whose risks they can identify, measure, monitor, manage, control and report and which are appropriate given its overall solvency needs. Specific exclusions from allowable assets versus IFRS include goodwill and intangibles however the resulting pool of allowable assets is still significantly broader than that allowed under Solvency I.

The Solvency Capital Requirement (SCR) is the normal target level of capital that an insurer will be expected to hold. It is calculated to ensure that the insurer can withstand a 1 in 200 year event and still meet its policy liabilities. Firms will have a choice over whether to determine the SCR using an internal model or a standard formula specified in the Directive. It is expected that the majority of larger firms will opt to use an internal model as this can reflect organization specific risks and may be likely to result in less capital required. However, an internal model will be subject to stricter standards and its use will need to be approved by supervisors. A breech of the SCR level will lead to supervisory intervention.

The Minimum Capital Requirement (MCR) is the minimum level an insurer must hold at all times. It represents the level below which policyholders are deemed to be exposed to an unacceptable level of risk. It is proposed to be calculated using a linear function which takes in to account, amongst other items, the level of insurance liabilities, premiums written and capital at risk. Breeching the MCR will result in regulatory action such as the prevention of new business being written or the initiation of winding up proceedings.

Pillar 2 is more qualitative and deals with increasing risk management standards and governance from within the firm. Under Pillar 2, firms will be required to produce an Own Risk and Solvency Assessment (ORSA) which will require forward looking assessments of the firm's risks, corresponding capital requirements and adequacy of capital resources. Supervisors will have greater powers to challenge firms on risk management issues and to impose additions to the SCR if they feel that there are any additional risks or factors not reflected in the firm's own calculations.

Pillar 3 deals with disclosure and requires greater levels of transparency for regulators and supervisors and for the general public. Under Pillar 3, an annual report will be required to be submitted to supervisors and a solvency and financial condition report will be made available to the public. The aim of these additional requirements is to for better quality and more up to date information to be available on a firm's financial position.

Conclusion

The breadth of Solvency II means a significant overhaul of how insurers manage their European business and its risks. 

This article was originally published in the ICAEW's Valuation Special Interest Group Newsletter for Q1 2011.

^1.Solvency II Directive: Chapter VI, Section 1, Article 75: Valuation of Assets and Liabilities.